Apr 3, 2011

Can you read it in more than one way? In how many ways can you read it?

Still confused?

Enough questions to start this blog.

In short: the more ways you are able to read this title, the more successful you'll probably be in defining and executing 'Stress Tests" in practice.

Let's dive a little deeper to illustrate this important 'multi interpretation talent' you need, to make stress testing a success.

Although there are far more ways (please add some interesting suggestions as comments to this blog) to interpret the title 'stress test stress test', we'll analyze in this blog two interesting interpretations that follow from the fact that 'stress test' can be interpreted as a noun or as a verb.

1. stress test [noun] stress test [noun]

Interpreting the title as two nouns could:

make you aware of the importance of stress tests

emphasize the importance of repetitive execution of stress tests

illustrate the feeling of disinterest and apathy that occur when important words are repeated to often without enough plowing depth..

2. stress test [verb] stress test [noun]

This perhaps the most interesting interpretation.
How can you really stress test your stress test?

The way we stress test at financial institutions like banks, insurance companies and pension funds, is basically more or less as follows:

Project historical crisis crash-data into the future. Simulate what would happen and take a look at the consequences

Take several economic scenarios. Project them on your balance sheet and see what happens.

To stress-test a stress test we have to develop a different view on stress tests.

A view based on the answer of the next leading question:

How many sides has a coin?

Let's demonstrate this new crucial view on a stress test.

A Different View on Stress Tests
Some examples:

Inverted Stress Test
An interesting way of stress testing is 'working the other way around': Try to define financial situations where you never want to end up in (e.g. equity< -5%, etc.) and try to imagine scenarios that could lead to this unwanted financial situation Paul Duijsens, ALM Principal Mercer Investment Consulting, mentions this approach).

Idiot Proof Stress TestAndrea Enria, chairman of Europe’s new banking regulator stated recently:A stress test is only as good as the scenarios you plug into it

Therefore, make stress tests 'idiot proof' as much as possible.
Once a stress test is developed, don't present it to the board directly. Organize a 'second opinion' from a professional company that's undependable and critical enough to seriously test and analyze your stress test and its assumptions.

Presenting a stress test without clear statements about the limits, vulnerabilities, constraints and shortcomings (every test has shortcomings) is like playing with fire and offering your board 'the wrong end of the stick'.

So we can add another conclusion quote:

A good stress test transparently presents its weaknesses

If nobody can find a weak spot spot in your stress test: ask a 5 year old child to ask some simple questions.....

Compare Stress Tests
Please think about :

'One stress test' = 'No stress test'

Comparing successively executed stress tests on assumptions, methods and outcomes is essential for a correct understanding of the impact and consequences.

Not only compare tests of your own company, compare also with tests of other financial institutions. Questions like: why do we as a [pension fund] have different assumptions and methods than an international [bank], are key to a correct understanding of your own risks.

Surpass Regulator Constructed Stress Tests
Regulator Constructed Stress Tests(RCS-tests) seem relatively easy to implement.
As a risk manager or board member you don't have to think about scenarios or methods. That's all been taken care of by the Regulator. Easy, isn't it?......... Wrong!

Heedlessly implementing RCS-tests is risky. First of all, the regulator's principles are partly biased. As an example, take the risk of treasury bonds on your balance sheet. Treasury bonds are commonly seen (and valued) as save (AAA-rating). However, some countries (Greece, Spain,Ireland etc.) have already been downgraded. Which countries will follow? Does the RCS-test includes this non-hypothetical risk? No? Does your own test includes this risk?

By definition regulators have to act and communicate in a responsible and 'prudent' way about government financial issues. If they wouldn't, world wide financial chaos would be the inevitable result.

The other side of this 'prudent coin' is that the actual risks are probably larger than can be concluded from the government (treasury) interest rates and interest spreads in a particular country. Here you'll have to develop your own risk model or - if data fail - formulate your own risk approach (get out!).

Key is that, given the general level of systemic risk, all financial institutions must be able to withstand haircuts on all their own sovereign debt holdings.

A 'third side' of this coin is the fact that regulators (in time) might decrease risks on certain asset categories that are not in line with your own risk view. Stay awake to prevent from becoming 'Supervisory Stress Compliant'.........

Unmask Derivatives
Market valuation with respect to derivatives is tricky business and probably only valid as long as there's a 'normal' market activity. Nobody is able to value derivatives under severe market conditions as is the case in stress tests. So, depending on the size and characteristics of a stress test, don't hesitate to to unmask your derivatives by applying a large discount on the value of your derivatives.

Conclusion
Stress testing is not for dummies, but for professionals.
It turns out that the more you're able to look different, critical and 'out of the box', the more stress testing will be successful.

Making your audience aware that a coin has three sides instead of two, is probably the essence of an actuary's or risk manager's profession.

It has become clear that analyzing assumptions, models, outcomes,constraints and shortcomings of a stress test is no superfluous luxury. So stress test your stress test!

Disclaimer

Maggid is an actuarial professional, and like every actuarial professional or human being, he makes mistakes. Maggid encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong.

Nothing written here, or in my writings at Actuary-Info is an invitation to undertake whatsoever action, in particular to buy or sell any particular security; at most, Maggid is handing out educated guesses as to what the markets may do. Maggid thinks that "The markets always find a new way to make a fool out of you", and so he encourages caution with every action, in particular in investing. Risk control wins the game in the long run, not bold moves.

Additionally, Maggid may occasionally write about accounting, actuarial, insurance, and tax or other specialized topics, but nothing written here or on Actuary-Info is meant to be a formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that Maggid can have no knowledge of.

The next additional general Disclaimer is also applicable with regard to Actuary-Info.